What’s up with Bitcoin?

Want to know why Bitcoin’s so bubbly? We explain how it got here, where it might go – and why MtGox always has the highest prices.

bubbles

Everyone loves bubbles – until they pop

What is a Bitcoin?

Quick primer: Bitcoin is a currency, as you’d imagine. But it might be better to think of it as a virtual commodity, a digital gold. Only a limited number of Bitcoins can ever be made (“mined”) and in fact, anyone can use their computer to dig for new coins although they’re getting very hard to find. The analogy breaks down here though, because unlike every physical commodity there is no instrinsic value, no industrial use for a Bitcoin. A Bitcoin is worth exactly and only what people think it’s worth.

The limited supply of coins makes Bitcoin deflationary, certainly relative to inflationary fiat currencies. As a fiat currency devalues over time, so a loaf of bread costs more in pounds or dollars, and so should a Bitcoin. However that effect is not nearly enough to explain the recent bubble.

There is an argument that people should rationally hold Bitcoins (reasoning: few more will ever be made so it’s a inflationary hedge, additionally if demand increases so will prices so there’s no point in selling now, especially because demand has increased in the past). However we don’t feel that’s the main reasons for the recent price appreciation.

Discerning Criminals use(d) Bitcoin

There was a small jolt when the FBI shutdown “Silk Road”, a market (for mostly illegal things) that accepted payments in Bitcoin. But Bitcoin had become a speculatory instrument well before the shutdown, and it was never clear that Silk Road was really driving prices at all. The problems in Cyprus earlier this year were a much stronger indicator of what could drive Bitcoin price changes – and of how Bitcoins are useful as a store of value.

Buying Bitcoins

The most common way to buy and sell BTC (the trading symbol for Bitcoin) is at an exchange. First you’ll have to apply for an account, prove your identity, transfer some money in, then finally send an order to buy, either at a specific price or at the current best price.

For a long time, the MtGox exchange in Japan was the world’s largest. However MtGox ran into some problems with the US regulators. This has made it hard for US citizens with accounts at MtGox to get their dollars back. Other BTC exchanges do not seem to have the same issues. As we’ll explain, this is definitely why MtGox has the highest BTC prices in the world and might also have triggered the recent price rises.

Twenty Dollars

As a finance professional, one of the very surprising things about the prices on MtGox is just how much higher than other exchanges they are. No other financial markets have $20 (7%) price differences between two exchanges. It’s not just a wider spread, as the bid (buying) price is $20 higher on MtGox than on other exchanges. If some other exchange has offers to sell right now for $170 why would anyone be willing to wait to buy at $190 on MtGox? And where are the arbitrageurs?

It’s the fault of those pesky US regulators!

Our belief is that US-based MtGox account holders, wanting to get their money back into the US, realised that they could (1) open an account at another exchange (one with less regulatory problems), (2) buy BTC at MtGox, (3) transfer their coins to the new account, (4) sell the coins, and (5) finally transfer their money out. This will probably lose something from crossing the spread twice, but it’s worth it to get the rest of your money back.

The trend starts

BTC is still quite an illiquid market so it does not take much pressure to make the market move. MtGox will have come under a lot of pressure to move higher, from US account holders buying BTC to transfer them away. All the other exchanges receive some smaller percentage of those coins each and soon after get orders to sell them, creating a smaller pressure on each to move lower. Net effect: MtGox has permanently higher prices, and the market gradually moves higher — especially because a Bitcoin has no fundamental value to keep things reverting to the mean.

And so the trend started. Thanks US regulators!

Breaking the dam

Then came probably the most important part: btcchina.com. As you can probably guess, this is a Chinese BTC exchange, allowing conversions to/from Yuan (Remninbi). The cause of the bubble is not that BTC China is very cheap to trade at (although it is), and it’s not that Chinese are culturally quite fond of speculation (although they do appear to be). It’s that the Yuan is a controlled currency but the government seems to have given it’s implicit blessing on converting BTC to and from Yuan – thereby breaking the currency controls.

This is a very big deal. Within a very short time this 2 year old exchange overtook MtGox and many others to become the world’s largest. Volumes are exploding. And when you have a lot of people chasing anything, especially a commodity with a fixed supply, you end up with exponentially rising prices, a.k.a. a bubble.

All the world’s a stage

It should be noted that as Bitcoin becomes increasingly visible to the public, demand – and thus the price – is likely to increase. This is another log on the fire for BTC. Our hypothesis is that the much more rapid ramp up in prices over the last months and weeks is as much due to the additional reasons given above.

Peering into the future

At Nous we believe that the future will see mainstream adoption of many alternative currencies – and Bitcoin might well be one of those. However if MtGox solves its bank problems in the US you can expect their prices to paradoxically fall, bringing them inline with other BTCUSD markets. That could easily cause a short-lived panic.

However BTC is probably most sensitive to Chinese policy right now. Any change in the Chinese Government’s views on BTC – positive or negative – will push it around. We wouldn’t want to be holding too many coins ourselves if China suddenly decides to outlaw BTC trading or somehow restrict cross-border BTC transfers. However until then, the price could well continue to rise.

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Of course the only way for anyone to be exposed to the upside but take no personal risk is to sign up for GAIN and start predicting. Nous is the inventor of the world’s first and only truly free option.

Disclaimer: The above is not investment advice. Trading involves risks. In fact we recommend that you never trade your own money and just use GAIN instead.